Race To The Top: The Duel Between Alphabet And Apple! by Aswath Damodaran, Musings On Markets
Apple and Alphabet, the two companies jockeying for the prize of “largest market cap company in the world” are both incredibly successful businesses, with unparalleled cash machines (the iPhone and Google Search) at their core. That said, the last month has been eventful for both companies, just as it has for the rest of the market, as their latest earnings reports seem to suggest that these firms are on divergent paths. Having valued Apple multiple times on this blog over the last five years, and bought and sold the stock based on those valuations, the most recent earnings report is an opportune time for me to revisit Apple’s value. Having never valued Alphabet on this blog, though I have valued it in my classes multiple times, its earnings report is a good time to initiate the process with a valuation.
The Apple Rollercoaster
Apple’s most recent earnings report came out on January 26, 2016, and it contained mixed news. On the good news front, Apple announced the largest quarterly earnings in corporate history and higher earnings per share than expected by analysts. The bad news was that these earnings were generated on revenues that were close to flat for the year, that iPhone sales were lower than expected and that the management expected revenues to stay weak through next quarter (in its guidance). The market’s reaction was negative, with Apple’s stock declining by 6.57%, a drop in market capitalization of more than $30 billion, right after the announcement. In the picture below, I capture the pricing reaction to Apple, with its earnings history as background information:
In summary, it looks like the market is weighing the iPhone and guidance bad news far more than the earnings good news in making its assessment, with Apple’s history of beating earnings every quarter for the last eight weighing against it.
[drizzle]To evaluate whether the earnings report merited the negative market reaction, I went back to the intrinsic value drawing board and updated my valuation of Apple, the last of which I posted in August 2015 and subsequently updated in November 2015, after its annual report (with a September 2015 year end) came out. My assessment of Apple’s value in November of 2015 was $134/share, but more importantly, the narrative that I had for Apple was that of a slow-growth , cash rich company (revenue growth rate of 3% in the next five years and a cash balance of $200 billion), with operating margins under pressure (declining from the 32.03% it earned as a pre-tax operating margin in the 2015 fiscal year to 25% over the next decade) and a very low probability of a difference-making disruption. Looking at the earnings report, it is true that revenue growth came in below expectations (but not by much, given my low expectations) and operating margins dropped, again in line with expectations.
The net effect is that my narrative changed little, and using a slightly lower revenue growth rate (2.2% instead of 3%) leads me to an updated assessment of value per share of $126 in February 2016 and almost all of the difference is coming from a repricing of risk (higher equity risk premiums and default spreads in the market). In keeping with my view that estimated value is a distribution, not a single number, I ran a simulation on Apple’s value in February 2016:
At the price of $94 at close of trading on February 12, 2016, Apple looks under valued by about 25% and at least based on my distribution, there is a more than 90% chance that it is under valued.
Alphabet surprised markets on February 1, 2016, with on earnings report where the company reported higher revenue growth than anticipated, coupled with higher profit margins. Since it was also the first report that the company was releasing as holding company, where it was breaking itself down by business, there was also excitement about what you would learn about the company from this report. As with Apple, I start by looking at the pricing effect of the earnings report, comparing, actual numbers to expectations and tallying the stock price reaction to the report:
Markets were impressed by both the revenue and earnings numbers and the stock price increased by 8% in the immediate aftermath, briefly leading Alphabet to the front of the market cap race.
As a counter to the market’s excitement, I decided to compare the narrative (and value) that I had for Alphabet in November 2015 (after their last earnings report) to the narrative (and value) after this one (in February 2016). In November 2015, my narrative for Google was that it would continue to be a dominant and profitable player in a growing online advertising market, growing 12% a year in the near term, maintaining its operating margins (left at 30% in pre-tax terms, in perpetuity).
It is true that in their most recent earnings report, Alphabet reported double-digit growth in revenues (impressive given their size and the state of the global economy) and higher operating margins than they did in the previous quarter. I left my original narrative largely intact, with revenue growth remaining at 12% and pushed up the target pre-tax operating margin to 32%, and arrived at a value per share of $631/share. Presenting Google’s value as a distribution, here is what I get:
At $682.40, the price at which the class C shares were trading at on February 12, 2016, the stock is trading at about 8% above the median price, with a 35% chance of being under valued. Since these shares have no voting rights, attaching a value to voting rights, will make the shares a little more over priced.
I know that one reason for Google’s restructuring/renaming exercise last year was an ostensible desire to improve transparency, but I think that there may be less here than promised, at least at the moment. There were a few things that became transparent in Google’s last earnings release, as captured in this picture of a key part of the earnings release from the company:
- It became transparently obvious that Google is almost entirely an online advertising company. All of Google’s other businesses generate collective revenues of $448 million, while reporting operating losses of $3,567 million. To even call them businesses is perhaps stretching the definition of the word “business”, since all they do well, right now, is spend money. While it is reasonable to cut them some slack because they are young, start-ups, there is nothing in this report that would lead you to think about them any differently than you always have, if you were a